Stretched valuations and political uncertainty loom over equities

Strategy: spreads too tight in EM hard currency debt and US high-yield

30 Jan 2017

  • Temporary factors hold back US growth
  • Eurozone growth on track
  • No reason for a policy change by the BoJ
  • Mexico and Turkey look vulnerable
  • Scope for emerging market rate cuts has widened

Equities gained further amid low volatility, with cyclicals outperforming defensives, and investors in a positive mood. We think the gains have taken markets further into overbought territory and so we remain underweight equities and underweight in US high-yield bonds versus cash. Apart from the stretched equity valuations, political uncertainty is high. At the time of writing, new temporary travel bans into the US for people from a number of Middle East countries have caused equities to sell off without bonds benefiting, while ‘peripheral’ eurozone bond spreads widened. This fits with our view that global trade faces political pressure.

US HEADLINE GDP GROWTH DISAPPOINTS, DETAILS LOOK BETTER

US fourth-quarter GDP growth missed the already low expectations, having slowed to 1.9% over a drag from net trade as exports slumped and imports leapt. This partly reflected a reversal of the third-quarter surge in soybean exports. Overall, net trade detracted 1.7 percentage points from growth. Inventory building added to growth for the second straight quarter and was stronger than in the previous six quarters. So it looks like the inventory correction, which has had an impact on business sales and industrial production, has ended.

Domestic final demand – made up of household and government consumption and business and residential investment – accelerated slightly despite the slowdown in consumption growth. So the exuberance in consumer confidence is leading to a surge in spending as employment growth moderates and real wage growth suffers from higher inflation.

Business and residential investment both added more to GDP than in previous quarters. Investment in equipment grew for the first time in five quarters. Orders for capital goods were up. Sentiment among produces has improved: the PMIs for the manufacturing and services sectors rose further and the composite index jumped to its highest since October 2015.

Overall, we are upbeat on the US economy. Growth should continue at or possibly above its long-term trend. We see three reasons not to get exuberant: rising inflation, the strong US dollar and the rise in bond yields. The recent declines in homebuilders’ sentiment and new and existing homes sales may signal that the cycle is becoming more challenging for housing.

EUROZONE LEADING INDICATORS CONTINUE POSITIVE RUN

As elsewhere in the world, leading indicators in the eurozone have been strong. The Economic Sentiment Index continued on its upward trajectory, driven by the services sector and consumers, but not by France or Germany. The composite PMI remains at its second-highest level since December 2015. In Germany the Ifo index fell unexpectedly, but from a high level. In France consumer confidence rose to its highest since October 2007. There may be uncertainty over the outcome of April’s presidential elections, but this has not dented consumer confidence.

Reasons to be positive about the eurozone’s prospects are a gradually improving labour market, a relatively cheap euro and supportive monetary policy. These have helped turn the credit cycle upwards, including bank lending to the private sector.

Data from the UK showed that the economy has now grown by 0.6% QoQ for three straight quarters, signalling there has been remarkably little fallout from the Brexit vote. From a business perspective the heightened uncertainty has been compensated for by the weak pound, which should support British exports. For consumers higher inflation should be negative. Consumer confidence, car sales and house price gains have moderated. The Bank of England faces tough choices: resilient growth and rising inflation argue for a more hawkish stance, but uncertainty about the impact of (a hard) Brexit argues for caution.

JAPAN: TUG-OF-WAR BETWEEN EXTERNAL AND DOMESTIC DEMAND

The positive news for the Japanese economy lately has come from exports. Obviously exchange rates and price developments have had a major impact, but by the end of the year, when export price deflation moderated, exports were rising. This stands in contrast with sluggish consumer demand. While the labour market appears tight when looking at the official unemployment rate, real wage growth is suffering from slightly rising headline inflation. The tug-of-war between exports and consumption will be the key development to watch in coming months. For the Bank of Japan, inflation is too low and the 0% target for the 10-year yield is too fresh to make any policy changes without losing credibility.

EMERGING MARKETS: TURKEY AND MEXICO UNDER PRESSURE

A downgrade by Fitch of its debt rating to below investment grade and a cut in the outlook to negative by Standard and Poor’s were a double blow to Turkey. Domestic and regional political uncertainty has hit growth. With a large current account deficit and relatively high foreign debt, Turkey is vulnerable to a shift in foreign investor sentiment. The central bank raised interest rates last week, but half-heartedly: it only lifted the upper limit of the floor of the interest-rate corridor. Since this reflected poorly on central bank independence, the lira weakened further.

With inflation falling in a number of emerging markets, the scope for interest-rate cuts has widened. This is most visible in Brazil, where real rates have jumped due to a sharp drop in inflation. Banco do Brasil may accelerate its rate cuts further. Real rates have risen in India, but as the fall in inflation is strongly driven by food prices, the central bank may be loath to cut rates. The Russian central bank may wait, although it has said that rate cuts are still possible.

ASSET ALLOCATION: UNCHANGED

We are positioned cautiously. We see still equities as expensive and overbought, even if the fourth-quarter US earnings season has so far not disappointed. The number of companies that have reported better-than-expected earnings and sales is lower than in the previous quarter, but earnings growth has turned positive, driven by healthcare, utilities, financials and IT. However, we do not see earnings as strong enough to lift equities higher in coming months.

The discussion about monetary policy and the relatively strong economic data in the eurozone have driven German 10-year yields higher. Looking at the still subdued core inflation and the slack in the labour market, we think German yields may be getting ahead of themselves. We have left our duration position at neutral though.

Credit spreads and spreads on emerging market debt have stayed low or even tightened further. We think that relative to the fundamentals, spreads are too tight now in emerging market debt in hard currency and US high-yield corporate bonds. We are underweight both asset classes.

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